GOD and Science in Economics -- Externalities and the Nirvana Approach Explained

Part I

Belief and Conviction Distinguished

GOD as used here is not what you think, and this is not about religion, except in a manner of speaking, it is. There is a curious and tricky distinction between belief -- founded upon epiphenomena without need for evidence or physical testing or corroboration -- and conviction based upon reason and evidence. Pretty much everyone understands that religious belief is based not on sensory or verifiable evidence, but rather on epiphenomenal "larger" thinking -- what caused the earth and skies, what is the purpose of it all, etc. In contrast, science and the scientific-rational way of thinking requires at least some plausible form of concrete evidence, and rests upon verifiability or repeatability.

This is not to disparage religion (or science), but to recognize the distinct nature and domain of each.

The questions asked by science and religion can be similar -- what caused the earth and sky, what is the purpose of this form of life or that -- but the method of "knowledge" or advancement in the field differs completely. Religion asks questions which are beyond testing or the ability to falsify, indeed requires this transcendence to achieve credibility. Religion starts with an answer -- God in most cases, and ends with it. For example, what makes the Bible not just a collection of stories is, to many believers, that it "comes from God" -- but this is beyond testing or evidence. Science starts with a hypothesis, but progresses only if a means of testing is found to lend credibility to the idea. The history of science is littered with "great ideas" which never gained traction for failure of a means of testing.

A familiar example is the theory of "continental drift", first given a name by Alfred Wegener in 1912 but having precursors going back several hundred years. W. J Kios noted that:

Abraham Ortelius in his work Thesaurus Geographicus (1596) ... suggested that the Americas were "torn away from Europe and Africa ... by earthquakes and floods" and went on to say: "The vestiges of the rupture reveal themselves, if someone brings forward a map of the world and considers carefully the coasts of the three [continents]."

Wegener posited that "centrifugal pseudoforce" from the earth's rotation caused the continents to split and drift apart, but various tests failed to confirm the explanation and the hypothesis remained just that for fifty years -- a matter of belief, not conviction, largely forgotten. It took the International Geophysical Year in 1958, during which deep ocean floor borings were made, revealing reverse magnetism of sequential rock layers, before scientists began to piece together a testable explanation for the phenomenon every school child notices -- the fit of the west coast of Africa with the east coast of South America. Today the processes of volcanism in deep ocean rills, sea floor spreading, techtonic plates, subduction and the rest is well established by repeated testing and confirmation. Scientific conviction has replaced hypothesis or belief. Wegener's phrase "continental drift", complete with new explanation, is firmly part of science, but his concept of "centrifugal pseudoforce" is long forgotten. The history of interplanetary "ether" -- once deemed a necessary part of physics -- courses a similar trajectory.

But this broad distinction between belief and conviction often breaks down in practice. Throughout much of science and including economics, threads emerge which appear to be evidence and reason based but which, alas, turn out to be a form of deeply held belief impermeable to or beyond the ready influence of evidence and reason. Thus (religious-type) belief masked as science occurs in economics and is difficult to locate, especially when the area of discussion is one highly charged with public interest and media "noise".

GOD, Externalities and Market Failure

One example of this is the concept of "externalities" and its use in economics. The word was coined by Nobel-winner Ken Arrow in the 1960s to describe the effects of transactions on persons not participating in the transactions. An example is hog raising. The farmer invests in feed, animals, land, equipment, time and other resources in order to raise hogs for market. Some of us buy bacon and ham through intermediaries but ultimately from the farmer. But the farmer's neighbor isn't part of this transaction and suffers noise, smell, and other negative olifactory stimuli from the hog-raising. And absent legal correction the price of bacon and ham does not reflect any compensation to the neighbor for the harm. Thus Arrow concluded that these transactions are not "Pareto optimal" in that someone (the neighbor) is worse off, and a better system would leave everyone better off and no one worse off. Since this "social product" is not accounted for by the market, Arrow saw a "market failure" and recommended governmental intervention to correct the divergence between "private" and "social" value.

Since Arrow's analysis, the concept of "externalities" and its companion concept, "market failure", have exploded. Many up and coming economics students seeking to make their way up the ladder to tenure and fame sought to explicate some new aspect of "market failure". Eventually this led to the attitude that "market failure" is ubiquitous, everyday and everywhere. Free markets were seen as fictive imaginings, beliefs held by those slave to some defunct early theorist without grounding in reality. Since "externalities" are ubiquitous and hence "market failure" is everywhere, the profession and academic economists increasingly came to advocate government intervention into the economy willy-nilly, seen as needed to correct the perceived divergence between optimal "social" and "private" products. Where economists led, media and politicians followed.

Lest you think we are driving down some esoteric and impractical road far removed from real life, realize that the deeply intrusive regulatory enactments of the last four years, including ObamaCare, Dodd-Frank, and the Stimulus, all rely ultimately for their intellectual justification -- whether consciously so understood or not -- upon the concept of "market failure", and its foundation-stone, the notion of "systemic negative externalities".

So it is critical that this intellectual foundation rest on firm ground, or these enactments -- and the many others similarly drawn -- promise greater harm than good, and in fact lead our economy down unproductive, income and wealth-sapping paths -- ultimately the road to ruin. As is readily shown, this path is not well supported and is in fact demonstrably false. The good news is, it can be avoided, and most top-flight economic thinkers have turned away from it. But a few old progressive voices with largely bankrupt approaches (Paul Krugman comes to mind) still corral significant media attention, especially given the prominent position of certain media in advancing political causes and populist agendas. Given this, it is critical that the truly informed wake up our politicians and educated populace to the reality behind the tendentious headlines and sensational journalism.

The history and development of these ideas -- "market failure", "externalities" -- are thoroughly discussed in "The Bumbling Colossus" at 227-241, and the reader is referred there for a more complete discussion. And a recent article in "The Independent Review" adds some very useful thinking to what is there already and is worth exploring here, which we do in Part II. Which brings us to GOD.

It is noticeable that proponents of the "market failure" and "externality" method of analysis conclude by advocating government intervention to correct the shortfall between "private" transactions and the "optimal social value". The unremarked assumption is that government regulation or control will advance or help, not retard or hurt, net social value. But uniformly those who rely upon "externalities" and "market failure" -- while the divergences they find are real -- fail to compare two real-life, existing alternatives, settling instead for the satisfaction of locating imperfections in an existing market and leaving unexamined the alternative (assumedly perfect) world of governmental interference. This is an example of "the Nirvana Approach", discussed in "The Bumbling Colossus" at 227-238. The assumption is, government is pure and its actions only beneficial. And the way government improves upon the market is by superior information and knowledge to what markets supply. In other words, the government acts with full knowledge, omnisciently.

Thus "externality" or "market failure" theory, following the "Nirvana Approach", assumes and leads to the requirement of an "Omniscient Administrator" -- Government's Omniscient Dictator, or government by omniscient decree (GOD).

But omniscience by anyone -- let alone some government bureaucrat -- is far beyond human reach. The fact government can hire legions of fact-gatherers doesn't alter this. Someone ultimately has to make the call, and no one has ever created a system which improves, for information gathering and dissemination, on the market (See TBC at 150-157, 178-180, 191-210).

That markets are imperfect (witness the stock market), is no objection, for the question is, what is better? Disregarding the impact of government interference (by regulation or outright control), and simply assuming, as the "market failure" theorists do, that the regulatory approach provides an increase in "social value" is not only a logical fallacy, it leaves unexamined the legion of studies and experiences demonstrating exactly the opposite -- that time and again government interference hurts, not helps. "The Bumbling Colossus" at 7-26 and 191-210 calls this "the Regulatory Illusion" and sets out some of the evidence (from mostly Nobel-winning economists) in support.

Remember, a free market relies upon one simple piece of information for the key element each participant needs to know to proceed -- price. The price of a good or service is the end result of an unfathonably complex combination of factors -- all the cost of goods, labor, land, taxes, alternative uses of capital, and so forth. In every instance in history where government has been asked to substitute "administrative judgment" or "fairness" for market pricing -- including most recently and dramatically the pricing of credit (risk) -- enormous harmful dislocations have resulted and costly failures ensued. And these are not small-fry situations. Thus students of the Soviet experience concluded it was Gosprom's inability to replicate or improve on market information transmission which underlay the economic collapse there (TBC at 178-180). Quite a long time to force-march a population of several hundred millions to a failed idea.

The examples in democratic societies are legion and closer to home. The continuing euro-zone troubles stem back largely to excessive government intrusion, in labor laws, restrictions on business, etc. The recent financial crash in the U.S. and on-going slow-growth "recovery" -- mostly caused by government policies interfering with market judgments of risk (the price of credit), most noticeably by HUD affordable housing (AH) mandates, but also including the Federal Reserve's loose money policies and efforts to "smooth" business cycles -- is a government failure of continuing, enormous harmful magnitude. See "The Bumbling Colossus" at 178-180, 253-257. One brought to us by "the best and the brightest" to boot. Any analysis of "systemic negative externalities" has to reckon these harms inflicted by (well intended) government. Yet the professional journals are filled with high-sounding articles which fail to do so.

In Part II we start with a definition of "systemic externalities" so everyone is on the same page and the hollow bottom of that approach can best be understood. We then proceed to an examination of "GOD in ObamaCare", "GOD in Dodd-Frank", and "GOD in Stimulus", so the prevalence in present policy of the false and harmful "Omniscient Administrator" can be clearly seen. Hold onto your hats and put your preconceptions to one side for a fun ride.